Tuesday, September 9, 2008

Chasing Bad Stocks is Your Brain’s Fault

According to Jason Zweig in his very interesting book, Your Money & Your Brain, the wiring of our brains is responsible for some of the mistakes we make in our approach to investing. Zwieg covers a number of human tendencies that can be traced to brain activity, but I will focus here on what makes us want to keep chasing stocks that ultimately disappoint us. For a complete reviews, see the Canadian Capitalist's review.

The new science of neuroeconomics involves scanning subjects’ brains while they take part in experiments. By seeing which parts of the brain light up and how intensely they light up, researchers can tell a lot about how we’re wired.

It turns out that we’re more excited during the time leading up to a potential reward than we are to actually receive the reward. So, when a gambler plunks his money down on lucky number 7 at the roulette wheel, he’s more excited watching for the wheel to stop than he is to rake in his chips if he happens to win.

The amount of excitement in the gambler’s brain increases with the size of the potential win. This means that we’re attracted to buying stocks where we can imagine a big payoff. This makes penny stocks much more exciting and rewarding than big bank stocks, at least until the penny stock becomes worthless and the investor gives up hope.

But, things get worse. Our excitement level is dictated by the size of the potential reward and not the odds of collecting that reward. This explains lottery tickets. Watching the numbers being drawn is exciting because of the multi-million dollar payoff even though the odds of winning are negligible. So, even though we lost money on the last ten penny stocks we bought, the next one is just as exciting to own.

Things get even worse than this. The potential for reward is more exciting if the potential for loss is present. So, if your penny stock is a sure thing, it’s less exciting than if you might lose all your money.

If ever there was an activity that requires people to remain calm and unemotional to succeed, it is investing.

4 comments:

  1. Thanks for the link. I think another reason (that I believe is discussed in the same chapter) is the tendency to take risks due to: (1) a regret for "near misses" (2) a "win" in the past. So, if an investor researched a risky stock but didn't buy (for whatever reason -- it may have been a valid one such as a down payment on a home) and it went on to become a ten-bagger, he is more likely to make risky bets in the future.

    Also, if a risky bet panned out, he may want to experience the same feeling again and keep making risky bets.

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  2. CC: It's no wonder that casinos make so much money. I wonder what the evolutionary advantage is of our brains being wired this way. Is it all just to make us want to take on the risky task of hunting animals for food with primitive weapons?

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  3. I do have a personal experience with what Canadian Capitalist was talking about. I had researched Amazon upon first hearing about it, and figured it was too expensive. The Motley Fool site soon after added it to a model portfolio, and it went on to its dizzying heights.

    Having let that one get away, the next time the Motley Fool added a stock: 3dfx, I bought it blindly, not wanting to miss out. That turned out to be a mistake, but in contrast to Zweig's assertion, I learned my lesson, and didn't repeat that mistake.

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  4. Gene: It's always interesting when a book puts your own actions in context. In Zweig's defense, he says that we need to use our reasoning abilities to overcome our instincts. It appears that you have done just that. Zweig would say that you still have an increased tendency to make snap decisions to buy speculative stocks. You can decide for yourself if you have this tendency that you overcome with reason, or whether you no longer have this tendency.

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